Momentum measures the amount that a financial instrument's price has changed over a given timeframe. Momentum is significant because it signals the strength of price trends. A healthy price trend tends to exhibit strong momentum, while weakening trends often have decreasing momentum indicating a trend reversal or correction. Momentum can also indicate short-term market extremes referred to as overbought and oversold levels. A bullish signal is generated when the Momentum rises above 0 and a bearish signal is generated when the Momentum falls below 0.
Momentum is calculated as a ratio of today's price compared to the price n periods ago. The formula is [Close/(Close n time-periods ago) times 100].
Momentum can be used as a trend-following oscillator similar to the MACD. A bullish signal is generated when the indicator bottoms and turns up. A bearish signal is generated when the indicator peaks and turns down.
If the Momentum indicator reaches extremely higher low values (relative to its historical values), a continuation of the current trend may be called for. For example, if the Momentum indicator reaches extremely high values and then turns down, one could assume prices will probably go still higher. In either case, only trade after prices confirm the signal generated by the indicator (e.g., if prices peak and turn down, wait for prices to begin to fall before selling).
The Momentum indicator can also be used as a leading indicator. This method assumes that market tops are typically identified by a rapid price increase (when everyone expects prices to go higher) and that market bottoms typically end with rapid price declines (when everyone wants to get out). As a market peaks, the Momentum indicator will climb sharply and then fall off--diverging from the continued upward or sideways movement of the price.
Similarly, at a market bottom, the Momentum indicator will drop sharply and then begin to climb well ahead of prices. Both of these situations result in divergences between the indicator and prices.